When people talk about investing, the conversation usually centres around returns – this is the exciting bit. Which fund is performing best? Which market is rising fastest? What opportunities are available today? How much of a return might I make!
What often receives far less attention is risk and how to think about it in the real world, i.e. how it impacts day to day.
In reality, risk is not simply about how much your portfolio might fluctuate (we know it will go up and down). Risk is the possibility that an investment shock could have a meaningful impact on your life and that impact might be something that you might not recover from finically or even emotionally. Understanding that distinction can completely change the way we think about investing and what risk to take and what risks to avoid as well as when – which is also a crucial consideration.
RISK IS PERSONAL
Two investors can hold exactly the same portfolio and experience the same market decline, but the consequences for each may be entirely different.
Consider an individual with a secure income, substantial savings, and no foreseeable need to access their investment capital. For them, a temporary market fall may be emotionally uncomfortable, but it is unlikely to change their lifestyle or financial security. Over time this is the best investor, one who can literally afford to take risk or as I prefer to say, who can live with volatility – i.e. not need to take money out when markets are down.
Now consider someone who relies on their investments to produce income every month. A significant fall in capital values, combined with the need to continue taking withdrawals, can create a much more serious challenge and can sometimes even be devastating.
The same investment risk can therefore have very different consequences depending on the investor’s circumstances.
The question isn’t simply, “How much risk can I take?”
The better question is, “How much risk can I afford to take without damaging my financial wellbeing?”
THE IMPORTANCE OF FINANCIAL RESERVES
One of the most overlooked aspects of risk management is having cash available.
Cash rarely attracts attention during a bull market in fact when markets seem to only rise investor behaviour can be to minimise cash and savings. It can appear unexciting when stock markets are rising and headlines are celebrating double-digit returns.
Yet cash serves a valuable purpose and is a crucial underpin of your investments – it’s the money that allows you to sleep at night when markets are more fragile.
Cash (bank accounts, NS&I, Premium Bonds etc) provides important protection and flexibility.
A cash reserve can help cover unexpected expenses, support income requirements during difficult periods, and reduce the need to sell investments at unfavourable times.
Think of it as the financial equivalent of a safety net. You hope you never need it, but when markets become turbulent, it can be one of the most valuable assets you own. I think that cash, especially in strained market conditions is the one thing that allows an investor to continue to invest rather than potentially capitulate in the face of falling market values be forced to sell at a vastly reduced value – a bit like a “fire sale”.
Investors sometimes see cash as money that is “not working”. The reality is that cash has a job; providing security, easy liquidity and peace of mind.
THE DANGER OF FOMO
Human behaviour is often a greater threat to investment success than market movements themselves. Markets (based entirely on past history) have a way of behaving that is predictable, they go up and down!
When markets rise strongly, it is natural to feel that everyone else is making money. Friends talk about investment gains, financial media celebrates new record highs, and stories of easy wealth become difficult to ignore. This is where fear of missing out (FOMO) takes hold.
Suddenly, risk begins to feel less risky and the entirely misplaced confidence that markets can only go up and can only get better seems strangely believable.
Investors who would normally be cautious can find themselves increasing exposure to areas that have already experienced substantial gains. They become less focused on protecting capital and more focused on chasing returns.
History provides many examples of how true this is and I have seen this in real life so many times.
During the late 1990s technology boom, investors poured money into internet-related businesses regardless of valuation. The belief was that traditional investment rules no longer applied. When the dot-com bubble eventually burst, many investors discovered that exciting stories do not always translate into sustainable investment returns.
A similar pattern emerged before the global banking crisis of 2008. The precursor to this was the absolute confidence that property prices could only rise. It seems obvious now but at the time, after so many years of rising property prices there was a very strong Fear of Missing Out and even some of the brightest amongst us (banking industry) got caught too by subprime mortgage debt. Confidence was high, risk appeared manageable, and many investors assumed markets would continue rising indefinitely. The subsequent downturn proved otherwise.
The lesson is simple.
Some of the biggest investment mistakes occur when optimism is at its highest.
OPPORTUNITY OFTEN FEELS UNCOMFORTABLE
Interestingly, the opposite is also true.
Many of the best investment opportunities emerge when markets are falling.
This sounds straightforward in theory. In practice, it is incredibly difficult and emotions like fear can govern the more rational and logical thought process. This is not to ignore the fact that none of us has a crystal ball and we cannot predict the future and businesses do fail!
When markets are dropping sharply, the headlines are rarely reassuring. Economic forecasts deteriorate, investor confidence disappears and fear becomes widespread.
This is why investing during a crisis often feels like trying to catch a falling knife.
Nobody knows precisely where the bottom will be. Markets can always fall further.
Yet history has repeatedly demonstrated that some of the strongest long-term returns have been generated by investors willing to commit capital during periods of extreme pessimism.
The challenge is that doing so requires both courage and preparation.
Without adequate reserves, investors may be forced sellers during market declines rather than buyers.
Having cash available and maintaining a sensible level of risk creates the ability to take advantage of opportunities when they eventually arise.
INVESTING SHOULD SUPPORT LIFE, NOT COMPLICATE IT
Perhaps the most important principle is recognising that investments are a means to an end.
The purpose of investing is not to achieve the highest possible return at any cost. It is to help fund the life you want to live.
For some people, that means preserving wealth and maintaining security. For others, it means generating reliable income. For many, it means balancing growth opportunities with protection against life’s uncertainties.
The right investment strategy is therefore not necessarily the one with the highest projected return. It is the one that allows you to meet your financial objectives while remaining comfortable during both good times and bad.
FINAL THOUGHTS
Successful investing is rarely about making heroic decisions or predicting the next market winner.
More often, it is about understanding your own circumstances, recognising the risks that genuinely matter, and avoiding emotionally driven decisions.
Markets will always experience periods of exuberance and periods of panic. The temptation to take too much risk when confidence is high, and too little risk when fear dominates even though the capital that is at risk in uncertain times is unlikely to disappear.
The investors who tend to fare best over the long term are not always the most aggressive or adventurous. They are often those who remain disciplined, maintain adequate reserves, and ensure that their investment strategy reflects the realities of their lives.
After all, the greatest risk isn’t necessarily seeing your portfolio fall in value as long as you have the right measures in place to allow you to be patient.
